Interview with Mohsin

IMF Survey: Rapidly growing, youthful populations hold great potential but also risks for the Middle East, which in recent decades has experienced sluggish growth and job creation. Is it approaching a tipping point where something must be done to meet rising expectations or risk a social crisis?

Khan: The idea that the region is reaching a tipping point is probably the right way to put it. It’s not at a crisis point yet, because the states are still by and large able to support the present population with subsidies and jobs, and in many of these countries, public sectors can still grow even more. That’s not a good idea. It’s not good economics or good policy. But if they have the resources, they can do it. Right now, the region’s biggest challenge is unemployment, and the answer to unemployment is faster economic growth—plus lower population growth, which then gets into cultural and social patterns. But I don’t think that anyone really has an answer to why the region has been growing more slowly on average on a per capita basis than most other developing country regions, especially given its relatively abundant natural resources.

IMF Survey: In North Africa, growth is relatively strong but still insufficient to bring down high unemployment rates. What should the top priorities be for the Maghreb? How important is greater regional integration?

Khan: The main challenge for the Maghreb countries, also, is unemployment, and there’s a consensus between the IMF and Algeria, Morocco, and Tunisia that the priorities must be maintaining macroeconomic stability, developing financial sectors, and increasing integration into the world economy— with a focus on stepping up regional integration. Very little trade takes place between these nations, although they’re trading much more with the European Union through association agreements. The argument for greater regional integration is that it could significantly boost growth rates (which now hover at 3-5 percent a year) and lower unemployment rates. The creation of a market of 75 million people would open up more opportunities for foreign direct investment. Investors could think: “If I set up in Algiers, I could easily sell in Rabat and Tunis.” There’s still a political problem between Morocco and Algeria on the Western Sahara, which I hope will be settled soon. The IMF plans to hold a seminar on regional trade facilitation in the fall for the Maghreb countries, and they’ve all agreed to attend.

IMF Survey: Iran, potentially a big player in the region, is reporting a growth rate that is higher than the Middle East average. How do you reconcile this with the country’s persistently high unemployment rate?

Khan: Iran has been growing well—largely thanks to oil price increases and economic reforms undertaken since 2002—but unemployment is still in double digits. The big question is: Could unemployment have declined by more, given the 7 percent rate that annual growth has averaged over the past few years? And what kind of growth rate is needed to make a significant dent in unemployment? This brings us back to the point that I was making earlier about unemployment and growth. If Iran’s labor force is growing at an annual rate of 3½ percent, it has to create 500,000 to 750,000 jobs a year just to absorb the new workers—something that is very tough to do. One answer would be to limit the growth of the population and labor force, but that would entail cultural and traditional issues centering on the desired family size. The alternative would be to grow even faster—say at 8, 9, or 10 percent a year. But for that to happen, even more reforms would be needed to stimulate the private sector so that it could create the extra jobs.

IMF Survey: The IMF Managing Director and yourself recently attended the London meeting in support of the Palestinian National Authority (PNA). Foreign ministers agreed on a series of steps to help the PNA strengthen its governing institutions, combat corruption, and unify security forces, and $1.2 billion was pledged toward the reform efforts. What are the economic prospects for the West Bank and Gaza? What is the IMF’s role in assisting the PNA? And how are we contributing to the peace efforts?

Khan: The economic situation is grim. Real income per capita is 35 percent lower now than it was in 1999 before the intifada, half of the population is living in poverty, and unemployment averages about 27 percent in the West Bank and 35 percent in Gaza. Economic prospects are highly dependent on political and security developments. The good news is that there’s an opportunity now for the Palestinian economy to strengthen and regain lost ground. At the London conference there was a clear sense of optimism.

How does the IMF fit in? We’re playing our part in the peace process by contributing to economic development, which also feeds back and helps political and security developments. At this stage, we’re focusing on technical assistance. We’re supporting the PNA in building sound economic and financial institutions. We’re also assisting with donor coordination by ensuring that everyone is aware of the overall macroeconomic objectives and financing needs.

IMF Survey: In a number of other Middle Eastern countries—Afghanistan, Egypt, Iraq, and Lebanon, among others—there have been movements toward democracy and more elections. What is the significance of this for the region’s economic outlook? How important are democracy and political institutions for growth?

Khan: These changes are pretty vital for the region. My own view is that giving people a stake in the country gives them a stake in the economy. It makes them more willing to invest labor and capital and take risks. I know it’s sort of a loose connection, but that’s where the connection lies. There are democracies that grow very slowly, and there are dictatorships that grow fast. But if you want a balanced private sector-oriented, market-oriented economic system, citizens need to be politically involved. They will push the government to be more efficient. We know that bad governance is bad for economic development, and good governance helps economic development. A democracy—no matter how poor it is— puts in place better governance.

IMF Survey: Where does the IMF stand on a loan for Iraq?

Khan: In September 2004, the IMF provided Iraq with about $436 million in emergency postconflict assistance to help it strengthen its capacity to undertake wide-ranging reforms—such as modernizing the banking system, adopting appropriate budgetary processes, and developing more efficient methods of tax collection. There’s been some progress and some setbacks, but the setbacks have mostly been connected with security and political developments. Iraq continues to suffer from shortages of fuel, gasoline, and electricity—which, in turn, give rise to inflation. Even so, we envision having an IMF-supported adjustment program in place by fall 2005, assuming that the election leads to a significant reduction in the security problems.

IMF Survey: In the past few years, Lebanon has been making efforts to deal with its large public sector debt. How do you assess its economic and financial prospects in the aftermath of the assassination of former Prime Minister Hariri last month and the ongoing political turmoil? Is the IMF assisting the Lebanese authorities in managing the current economic situation?

Khan: This is yet another country where the culprit is politics; nothing has changed in the economic fundamentals. Even though Lebanon has some vulnerabilities, it has been very successful in attracting foreign financial inflows. Its financial system works on credibility, trust, and confidence. Despite the very high debt ratio, investors are ready to put their money into the country because of family ties and attractive interest rates. It has also become a very popular tourist spot, and its diaspora is extremely wealthy, continuing to send large amounts of money every year. At this point, the IMF is continuing to advise Lebanon on how to maintain macroeconomic and financial stability. Fortunately, Lebanon has some very smart people running it, and they seem to know what they are doing in this current critical situation.

IMF Survey: Another postconflict country, Afghanistan, has been seeing better growth, but it’s still struggling to meet basic needs and reduce poverty—not to mention diversify away from poppy production. What steps does Afghanistan need to take?

Khan: The poppy figures are pretty amazing. The drug economy was about 60 percent of GDP last year, which is unparalleled anywhere. In Latin America, people have always thought 10 percent was huge. However, tackling the drug economy almost poses a moral dilemma: you know it has to be eliminated, but if this were to happen very quickly, it would have dire consequences for the population in terms of employment and wages. It would be a horrendous macro shock. So we’re trying to help the authorities evaluate the macroeconomic impact of poppy production on the balance of payments, exchange rates, the fiscal situation, and so on. Basically, two approaches are being taken: eradication and finding alternative livelihoods in agriculture. But it’s a slow process.

IMF Survey: Libya is among a number of countries in the region that have been making efforts to reform and open up their economies. How do you evaluate these efforts?

Khan: I’m cautiously optimistic. Libya has asked the IMF, along with the World Bank, to take the lead role in developing a comprehensive reform program as it moves from being a planned to a market economy. Unlike most transition economies, however, it has oil, and that can be both a blessing and a curse. On the plus side, the country wants to reform and is ready to use that oil wealth to soften the impact of the reforms on the population, but the very existence of the wealth makes some people reluctant to reform. The bottom line is that you must have committed reformers who have the ear of people in power. Fortunately, there appears to be such a group of reformers in Libya, including the son of Colonel Qaddafi, who are well placed to carry out their reform plans.

IMF Survey: Of course, the oil-producing countries have been enjoying large increases in revenue from the high energy prices. What is the outlook for these countries? How about the oil-consuming nations in the region?

Khan: Oil prices are going to remain high for a while, because there’s a lack of global capacity, and demand continues to grow, particularly in China and the United States. Eventually, this may hurt oil-consuming countries, but so far, we’ve seen little impact on their growth and balance of payments because they’ve been able to boost exports.

As for the oil producers, this is a boom. They’re going to be awash with revenues. The big question for them, and also a question for the IMF, is what they should do with this wealth. Some say they should save it for a rainy day. Others argue that if the oil price increase is permanent, they should spend it— wisely, of course. Some of these oil producers have aging infrastructures and pressing social needs. Moreover, it’s very difficult from a political economy perspective to convince a country with 20 percent unemployment (and maybe 30 percent youth unemployment) to save the wealth for later. It’s a pointless argument, given political realities. Even if the country contracts out to foreign companies, it can always insist that a certain percentage of the labor force be hired locally. So there are ways of generating private employment through government spending.

IMF Survey: Is there any good news out of the relatively poorer Central Asian transition economies?

Khan: Definitely. In all of the countries—even though it’s a very diverse group, including some oil producers—there’s broad macroeconomic stability, low inflation, very stable exchange rates, manageable debt loads, and in contrast to the rest of the region, very impressive growth rates. Of course, they came from a low base, so much of this is catch-up. Their economies collapsed after the fall of the Berlin wall. But growth rates have averaged 6-10 percent or even higher, and we’re talking about several years of this kind of growth. The challenge will be to reach a sustainable growth rate, probably in the 6-8 percent range. That should help reduce poverty and unemployment, which are still high but declining.

IMF Survey: You’ve had the benefit of an extensive research background and some time in country operations. What do you see as the most important unanswered questions relating to the region’s economic performance?

Khan: I would say, unfortunately, that the questions concern perhaps the most important variable of all—economic growth. At the IMF and the World Bank, we’re constantly pushing growth and poverty reduction, but we don’t truly have a good handle on what drives growth. Before moving to the Middle East and Central Asia Department, I thought that we really knew what would stimulate growth in countries, and in a general sense we do. But when you try to turn that knowledge into operational policies, it can be very difficult. For example, some people believe that one of the most important factors in determining growth is geography— where you’re located, whether you have a coast or not, whether you’re landlocked or not. Well, that’s a good way of categorizing countries, but it has no policy relevance whatsoever. I mean, what are you going to tell a country that is landlocked? Get yourself a coast? And these days it’s fashionable to say that institutions drive growth. That’s certainly very plausible, and I’m sure, in theory, it’s true. And long-term empirical analyses probably show that countries with better institutions grow faster than countries with relatively worse or no institutions.

But when you sit down with a government official who wants to know which are the critical institutions, you come to the problem. Rule of law? Property rights? Better judicial and legal systems? The reality is that we don’t have a firm handle on that yet. It makes me realize that many results that are interesting in research, and which seem relevant and applicable, have little operational value in practice until you take them further. So I can see why sometimes there is a disconnect between what goes on in the IMF’s research and what goes on in its country operations. I know it may come as a surprise to hear this from someone who has spent so much time doing research, but it’s true. I believe I’m still learning.

IMF Survey: We have talked a lot about what the region must do to boost growth, reduce poverty, and increase the standard of living. What do you see as your biggest challenge in your efforts to help?

Khan: The late Rudi Dornbusch—a person whom I, like many others, admired greatly—said to me in 2003 that the Middle East and North Africa would be the most interesting region for an economist to work on over the next decade. As in many things, he was absolutely right. This is clearly the most interesting and challenging assignment I have had in the IMF. My objective is to ensure that we offer the countries in the region, including Central Asia, the best possible economic analysis and advice. I hope to be judged by that objective.